First Interstate Bancsystem Inc (FIBK) 2010 Q2 法說會逐字稿

Good afternoon, and welcome to the First Interstate BancSystem second-quarter earnings conference call. All participants will be in listen-only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. (Operator Instructions).

Please note this event is being recorded. I would now like to turn the conference over to Marcy Mutch. Please go ahead, ma'am.

Thanks, Andrea. Good morning, or good afternoon, for those of you east of us. Welcome, and thank you for joining us for our second-quarter earnings announcement.

Today, we will be making some forward-looking statements regarding quarterly provisions for loan losses, income from the origination and sale of loans, loan growth, and nonperforming assets. We may also make other forward-looking statements, including statements about our plans, strategies and prospects. I need to remind you that all forward-looking statements are subject to various risks and uncertainties. Therefore, our actual results may differ materially from those expressed in or implied by such forward-looking statements.

For a full discussion of the risks and uncertainties associated with our forward-looking statements, please refer to our securities filings, in particular the Risk Factors section of our most recently filed Forms 10-K and 10-Qs.

Joining us from management this morning are Lyle Knight, our Chief Executive Officer and Terry Moore, our Chief Financial Officer. Lyle will begin by giving you a general overview of this quarter's results along with observations on our market. Terry will follow up with more specific information behind the quarterly results and provide a general view of credit quality information. Also with us this morning is at Ed Garding, our Chief Credit Officer. Ed will be available during the Q&A time to address questions concerning our loans and asset quality.

At this time, I'd like to turn the call over to Lyle Knight. Lyle?

Thank you, Marcy. Good morning, and thanks to all of you for joining us on the call.

Last night, we reported earnings for the second quarter of $5.8 million and diluted earnings per common share for the quarter of $0.14. This compares to $12.5 million in earnings and diluted earnings per common share of $0.39 for the second quarter of 2009. Please keep in mind anytime we make comparisons back to 2009, the comparisons are prior to the IPO, which added 11.5 million shares to our equity for 2010.

We've had positive trends in revenue generation in the second quarter, with increases in both net interest income and noninterest income, as compared to the first quarter of 2010. However, our earnings were significantly impacted by a $19.5 million loan loss provision, which is $7.8 million more than we recorded in the first quarter.

While we are disappointed in the increase over last quarter, we do take comfort in the fact that the weakness in the portfolio is not broad-based and that the majority of our credit issues are narrowly focused in three geographic areas. These three geographic areas make up only 21% of our loan portfolio.

Our credit costs continue to be largely related to the three markets we discussed with you last quarter. They are the Flathead area around Kalispell, Montana; the Gallatin Valley area around Bozeman, Montana; and the Jackson Hole area in Wyoming. All of these markets have a common underpinning, and that is they are largely impacted by out-of-state influences, and their economies are dependent upon the resort and second home communities.

We continue to see credit quality deterioration due to depressed real estate values and limited sales activity in these areas. Now Terry will give you more color on these markets and break down the numbers in more detail in just a few minutes.

But I want you to know that outside of these three markets, we are not seeing any significant new areas of concern in the portfolio. In fact, based on our internal accounting, approximately 40% of our markets are still returning ROAs in excess of 100 basis points.

Now, while earnings were impacted by the increase in loan loss provision, we continue to be solidly profitable and generate earnings just as we have over the last 22 years. Our balance sheet remains strong as a result of the provision, which, as you know, is exceeding our net charge-offs. The allowance for loan losses of $114 million has increased 14 basis points to where we now stand at 2.51% of total loans, up from 2.37% of total loans as of March 31.

As we told you on the road show in March, and as we repeated at our first quarterly call, we expected to see continued growth in our NPAs. And of course, this bears out -- these reports today bear out that expectation.

As of June 30, NPAs are $200 million. But, remember, that is only 2.7% of total assets, and that compares with 2.5% of total assets as of March 31.

Now we continue building our reserves and will continue to reserve more than we charge off until we, as management, are comfortable that we've seen a consistent leveling or a decline in our nonperforming assets.

Now, on the good news side, we've seen a slight increase in loans, and that comes primarily in the commercial loan portfolio, which increased almost $50 million in the second quarter. This increase came from a combination of both new relationships that we have acquired, as well as some increased demand from our existing customers.

We also saw some growth in our ag portfolio during this quarter. So after six quarters of negative loan growth rates in the overall portfolio, we see a net increase this quarter, finally. While one quarter certainly does not make a trend, we see this as positive, and we are encouraged by these signs.

During this same time, total deposits were also up slightly with solid growth in non-interest-bearing demand and savings accounts and a corresponding reduction of balances in our higher-cost time deposits.

As we've said before, while we were slow to enter this recessionary period, we are also slow to exit. We find ourselves right along with the rest of the nation. And I can tell you we are experiencing slower than hoped for economic growth.

However, in the majority of our footprint, we are seeing stable employment and stable property values. As of the end of March, housing values on a state-wide basis had dropped from the peak by only 2.2% in South Dakota. This is from the peak. Only 6.3% in Montana; and approximately 11% in Wyoming. And Wyoming is largely impacted by large decreases in the Jackson Hole area.

The national average decline in value as you know is 18.4%, so we feel as if our states and particularly the areas outside of those three resort areas are weathering the downturn very well.

In most of our footprint, unemployment is well below the national average. However, again, in the Flathead and Jackson Hole markets, unemployment rates are the highest in our states with rates approaching or, in some cases, around the Flathead, in excess, of the national average of 9.5%.

As we begin to see life in our national economy, we will expect Wyoming to experience growth because, as you know, Wyoming is energy-driven. And we expect that their resources, such as coal, natural gas, and oil will see an upswing when the nation sees an upswing. And like energy, the other industries that drive our economies include agriculture and tourism, and they both remain solid.

So as we have said before, our footprint continues to protect us from feeling the full impact of these difficult economic times with the exception of those isolated pockets that we have discussed.

With that high-level review, Terry, would you take them into the details?

Thanks, Lyle, and thanks to all of you for joining us today. I will provide a brief overview of some of the key numbers included in our earnings release last evening.

As Lyle mentioned, we generated net income to common shareholders during the quarter of $5.8 million or $0.14 per common share. This compares to $10.3 million or $0.32 per common share in Q1. And as Lyle mentioned, with the addition of 11.5 million shares issued in conjunction with the IPO, our weighted shares outstanding for the quarter increased from $31.9 million in the first quarter to $42.9 million this last quarter, having an impact of about $0.05 per share on a quarter-to-quarter basis.

Our net interest margin was 3.96% in Q2 compared to an even 4% last quarter and 4.04% in the second quarter of 2009.

As we mentioned last quarter, we anticipated a 5 basis point decrease this quarter over last, which is reflective of carrying the funds received from the IPO in lower yielding investments. Currently, our IPO proceeds are invested at the Fed funds rate.

Our cost of funds decreased 10 basis points during the quarter. This was primarily due to a drop in the average rate we were paying on savings and time deposits, along with a shift in the mix of deposits out of higher-yielding accounts and into lower-yielding accounts.

Our low funding costs and a strong core deposit base should continue to result in a stable net interest margin.

Investment securities increased $112 million during the quarter. These additional funds have principally been invested in available for sale agency securities with average maturities generally not exceeding four years.

Non-interest income increased by $1.5 million to $21 million from $19.5 million in Q1. This increase was primarily due to an increase in loan originations for purchased homes, partly driven by the necessity to close on loans qualifying for first-time homeowners' credits.

Our current pipeline of residential mortgages reflects July and August will be strong. And as rates remain low, we should see a positive impact from residential mortgage originations.

Non-interest expense increased $2.7 million or 5.1% from the first quarter. However, excluding OREO costs, which I will discuss in just a moment, non-interest expenses were flat. Our operating efficiency ratio, if adjusted for OREO costs, improved to 62.3% in Q2 from 64.3% in the first quarter. This reflects our ability to manage expenses successfully during these more demanding economic times, as well as our positive trends in revenue generation.

We continue to see weakness and further depression in property values centered on real estate development in the three geographic areas Lyle mentioned in his opening remarks. Again those are the Flathead area, the Gallatin Valley area, and the Jackson Hole area.

We're also seeing high unemployment rates in those areas, with Flathead County at 11.5%; Gallatin County at 7.5% as of June; and Teton County in Wyoming of 9.4% in May.

The second-quarter provision for loan loss of $19.5 million is equivalent to 1.73% annualized provision to average loans.

The allowance for loan losses continues to build, totaling 2.51% of total loans as of June 30.

Of the $19.5 million provision, $14.5 million was allocated to specific reserves with the remainder being part of the general reserves. 77% of the Q2 specific reserves were attributable to the three markets I've just mentioned.

Increases in nonperforming loans are primarily reflective of the effects of current economic conditions, which have resulted in decreased property and collateral values. In the last 12 months, we've seen reductions in appraised values in these three depressed markets of between 10% and 25% with the most severely impacted area being around Jackson. Given the slow recovery of the national and regional economies, and that we are not confident we've seen the bottom of depressed real estate prices in the three markets, we will experience elevated provisions for the next several quarters.

NPAs are continuing to grow and we anticipate this trend will continue for a few more quarters. NPAs are $200 million or 2.77% of total assets as of June 30.

Approximately 85% of the loans with balances exceeding $1 million that were placed on nonaccrual during Q2 are located in these three depressed markets. Those markets now comprise 56% of our nonperforming assets while representing only 21% of our total loan portfolio.

79% of our total NPLs are comprised of commercial and construction real estate, with 53% of this total in the Jackson market, Flathead market and Gallatin markets. Our allowance to coverage of NPLs remains solid, at 72%.

We are still not seeing any significant trends of weakness, however, in commercial real estate in our other major markets.

Our OREO balance decreased primarily to a $3.1 million write-down to estimated fair market value. Nearly all of this is attributable to two properties. One property is a residential property in Jackson Hole, Wyoming, and the land development property that was pending sale and has subsequently closed in Kalispell.

As one would expect, we are dedicating additional resources and oversight to the depressed markets we've been discussing to assist the credit quality issues. We expect these steps to help mitigate credit costs to the Company.

I will close by commenting on our capital levels. As of June 30, our Tier 1 capital ratio of 12.87% and our total risk-based capital ratio of 14.81% reflects continued strength of our capital position.

Now I'll turn it back to you, Lyle.

Well, thank you, Terry. Before we open the floor for questions, let me comment on a few things.

First of all, there's been a lot of talk about the impact of the new regulatory reform enactments. I want to confirm that because we did not engage in the courtesy overdraft program, the impact of this change to us will be fairly insignificant. As for the reforms around the interchange fees, it's still uncertain to me what the impact on the industry will be or the impact on us.

Now in June, last month, our Company was named to the Russell 3000 and 2000 indices, along with the AVA NASDAQ community stock-index. Now we are pleased with these announcements because we look at these as important ways to enhance our visibility with both analysts and investors.

Three months ago when we spoke to you, we felt like the economy was beginning to gain some traction. I'm still optimistic, but sensing now a longer than anticipated period of recovery. I smiled at Chairman Bernanke's comments last week when he said the economic outlook was unusually uncertain.

Well, you take that comment and with what we now project to be a pretty prolonged period of low interest rates confirms to me that this economy is going to be soft for the next several quarters.

We're fortunate that even with two high unemployment areas that we have continually mentioned throughout this call, being primarily Montana in the Kalispell area and Wyoming in the Jackson Hole area, the states where we do business still have very enviable unemployment rates. If you look at the list, you will find South Dakota is ranked second in the nation -- second lowest in the nation for unemployment. Wyoming is hanging right in there at eighth lowest in the nation, and Montana is the 16th lowest in the nation. That's provided us with the health we have needed to endure these economic headwinds.

Still, we want to continue to demonstrate core earnings and the core earnings strength during this prolonged period of challenge and economic stress. Since the IPO, our emphasis has remained on our core principles. We've not changed our business model, nor have we changed the way we deliver our products and services.

We have a conservative bias in all aspects of our Company, all aspects of our operations, including credit but also including the other ways that we do business. We are very focused on the long term. We're focused on strong relationships with our customers, with our employees, and with our communities. While our current level of performance is not what we have been accustomed to nor what we are pleased with, we do continue to be solidly profitable, and we are more than capable of absorbing anticipated credit losses.

In these difficult times, we believe our unquestionable reputation as a strong and healthy financial institution continues to differentiate us from many of the other banks in our markets. We have a proven business model. Remember, we have very deep customer relationships and a great team that puts First Interstate in a position, we feel, for long-term success. With that, let's open her up for questions.

(Operator Instructions). Matthew Clark, KBW.

Good morning, guys. Can you update us on your potential problem loans? I think that's a number you guys provided in the Q. And I think it was $254 million last quarter.

Matthew, this is Terry. It will be disclosed in the 10-Q, and so we're still working on that. The 10-Q will be filed perhaps late next week and those potential problem loans have increased, as you might have expected, and largely focused around those three markets once again.

Okay. And as it relates to those three markets, you mentioned that's about 21% of your loan portfolio. Can you give us any sense for -- or can you carve out -- maybe an easier way to do it is, what percent of that 21% might be criticized classified? Or is there another way to measure kind of what you -- trying to wrap your arms around what the exposure is of concern.

This is Ed Garding, Matthew. And I think I understand your question. And of course it varies by market. So if you took all of the loans in the Jackson market, I think your question is, what percent of all of those loans are criticized or classified? And I don't have that in front of me, but I can tell you that I believe it's around -- in the Jackson market, I believe it's around 20% criticized. And, in a Flathead market, it's around 16% criticized. And in the Bozeman market, around 15% criticized.

Okay. And then, does that criticized number include nonperformers or not?

Yes. That's -- when I say criticized, I'm talking about nonperforming, substandard, doubtful, loss -- all of that.

Okay, thank you. Okay. And then, is it fair -- sorry, I'm just looking at my questions here. Is it fair to assume that charge-offs will likely peak after the peak in nonperformers?

That's fair.

Okay. And then lastly, can you just update us on any margin guidance if you have any?

Matthew, this is Terry. We don't have any specific guidance, but as we've indicated, we expect our margins to remain stable. You can imagine, as I mentioned last quarter, one of the key factors will be to what extent do loans grow versus shrink? Well it will certainly have a big impact, and you can see loan growth has helped us this last quarter, and so if we were to see that, that would help margins and vice versa.

Also, of course, we still have opportunity for our cost of funds to decline. But, on the other hand, we have continuing decline in our investment yields as the portfolio reprices through payments in that portfolio. So I think probably the larger indicator will drive around the arena of what loan growth does over the next year.

Okay. And then one more I just had; I forgot. The nonperforming loans of $135 million, you mentioned that $70 million is construction and $54 million is CRE. My sense is that some of that CRE or a lot of it is construction-related CRE. Can you maybe size up how much of that is tied to construction or -- and then how much -- so, how much of construction is within that $54 million? And then how much is the total construction-related CRE portfolio?

We're shuffling some papers right now, Matthew.

No worries.

I'm still shuffling. Sorry. I think -- so I think -- out of $54 million in nonperforming real estate, $11 million is -- pardon me -- not $11 million; it's $26 million is construction. And you said how much of that construction is related to real estate development, and all of it is.

Well how much -- I'm just wondering in the commercial real estate portfolio overall, how much construction exposure do you have?

I think it's about $105 million. It's been going down. $86 million.

Okay. And that's -- is that -- residential-related? Does that include commercial-related construction as well? Or is that just residential-related commercial real estate?

That's what we would call commercial.

Okay.

But we would classify it as commercial if it was a real estate development.

Got it. Okay, thank you.

Brad Milsaps, Sandler O'Neill.

Good morning. I just wanted to see if you could talk a little bit about the acquisition development book within the construction portfolio. It didn't really move a lot this quarter -- down a little bit. Just kind of curious what you have in terms of renewals that might be coming up say over the next 12 months and just kind of your general outlook for kind of what your expectations are there?

On -- you are talking about construction and real estate development. I would say that 100% of them are going to come due in the next 12 months because typically we don't write a note like that for more than 12 months. Occasionally, on very large projects, we will have an 18 month construction note, but again, I would say about 100% will come due in the next 12 months.

And then the second part of your question I believe is what are we seeing, and it's kind of back to the story we've been telling, and that's that in 80% of our territory, it's pretty stable, and so we aren't seeing problems cropping up there. And in those three areas that we mentioned, they are still very much declining markets, and so, we are seeing problems there. And, we're not seeing much in the way of sales so far this summer. And so, certainly as they renew, I think the problems will deepen in that 21% of our portfolio.

Can you -- and Ed, I may have missed this in your initial comments, but can you tell us what percentage of that portfolio would be in those three problem markets that you guys outlined?

I'm not sure I understand -- are you saying what percent of that portfolio is construction and real estate development?

No, I'm sorry. Of that acquisition and development portfolio, what percentage of that portfolio would be in the Bozeman, Flathead, Jackson markets? Of that let's see, roughly $371 million?

Oh, okay. And it's almost exactly the same as we've been saying for the total portfolio. It's about 21% of our total acquisition and development portfolio.

Okay, great. Thank you very much.

Ryan Nash, Barclays Capital.

I think Terry noted to it and you also talked about it in the release that quarterly provisions are expected to remain high until you see evidence of leveling off or decline in your NPAs. So first off, how should we think about the new quarterly run rate for provisions? Were there a couple of lumpy credits in there that really drove the increase? Or was it more broad-based and we kind of think about this as a new run rate level?

Terry, will you take that one?

Certainly, it's mine. Thanks, Ryan. No, I don't know that we have a run rate, but certainly we did see some specific credits in those three particular markets that dominated the additional provision. And so, to some extent, Ryan, as those three markets go, so will our provision over the next few quarters. So, perhaps the provisions in the next few quarters would be more approximate to what we recorded in the second quarter, but they may come back down.

When you say lumpy -- yes, they would be -- if we took a dozen credits, that would account for the lion's share of it -- of the increase. And so we'll just have to see how it plays out, but we would expect to see high -- high being -- we're used to something like a 15 basis point net charge-off. So when we start talking 1%, that's very high. So, it will be some time with some higher charge-offs and higher provisions. We're not giving any guidance because we're not sure exactly how those will play out, but we believe that those three markets will have the greatest impact on whether the provisions move up or decline somewhat over the next few quarters.

Ryan, this is Lyle. Let me add that the word lumpy credits is appropriate because that's exactly what we saw a handful of lumpy deals that tipped us this quarter.

But having said that, we know the regulators are tougher when they go into banks. We're hearing that from our peers, so that's got us a little concerned.

Secondly, the buying season is pretty slow in these resort areas. When we spoke to you at the end of the first quarter, it was still wintertime, and we were more optimistic that the national economy was getting traction and more optimistic that we would see the out-of-town buyers that come into these three resort areas. But, we have not seen the level of buyers that we'd anticipated. So those are a couple of biases that would throw us on the negative side.

Got you. And just in terms of your delinquencies that we saw an increase in the 30 to 89 and also in the 90 plus. And I just wanted to know, how should we think about inflows to NPAs over the next couple of quarters? I know that you guys had maybe talked to potential peak later in the year. I just wanted to see what your stance was towards that.

I could tell you with some specific numbers, not dollar amounts, but I can tell you that most of that jump in past dues was related to four loans from the Jackson area and four loans from the Flathead area. And, in looking at them, I could tell you that there is a high likelihood that six of those eight loans will end up on the nonperforming list.

Got you. All right, thanks.

(Operator Instructions). Jeff Rulis, D.A. Davidson.

Good morning. I guess the margin question was asked, but taken a different way, Terry, you sort of alluded to the one-time or not necessarily one-time on the IPO proceeds causes some contraction. Potentially, do you track margins by month? Do you have those averages?

Yes. I don't have it right in front of me, but we do track it by month. And, it has been very stable this year each of these months. And so it will tick up or down any given month by 1 or 2 basis points.

Within Q2, how was the trend?

It was stable. And if anything, perhaps June might have been up a little bit from April and May.

Got you. Okay, that helps.

Jeff, this is Lyle. We have a lot of energy focused on reducing our cost of funds. And we've told you that because of our market share, we have pricing power. We're putting it to the test right now. So Terry talked about the negative potential against margin being the investment portfolio, and a fairly flat loan growth. But the positive side is we're working to reduce -- continually working to reduce our cost of funds.

Okay. And then on the loan growth side, a nice number surprise within the group. I guess any geographic focus of that C&I strength in any certain markets, or was it fairly broad-based?

That was fairly broad-based.

Okay. Thanks.

Scott Haugan, Tygh Capital.

Hey, this is Scott Haugan. You know, we had Glacier report this morning as well, of which I think Glacier -- Glacier Bank is their biggest bank. And, they had a decline in NPAs, provisioning and delinquent buckets; I think all of their buckets that they report declined quarter over quarter and year over year. So, do you guys feel like your credit department or your loan officers, are they just more late to the game identifying these problems in Kalispell, Bozeman and Jackson? Or why do you think you are showing the weakness now versus -- Glacier was reporting these type of weaknesses in those areas I think between six and eight quarters ago.

First, I would say we saw the weaknesses six and eight quarters ago also, and we were not reporting them because we were not a public company. And, we just became a public company in March, and so that would be one difference. There's no question that the recession came to our area later than the rest of the country, and we are in the same market as Glacier in that Flathead market. And so you would think that we would mirror that; and it sounds like based on their report we haven't.

But I would say one reason that their percentage of nonperforming has gone down is because they've charged them off. And if you look at the previous quarters, they had some pretty big net charge-off numbers, and that's part of what -- part of the way you get rid of the problems is to write them off. And I'm not saying we're not going to have any losses, but it looked to me that that's where some of that went.

I guess is there any specifics on the delinquent buckets by geography? You said there was about four loans in Jackson, four in the Montana area. But, is there any way to think about how long or how elevated the loan loss provision could remain for the next three, four quarters?

Well we're all sort of shrugging right now because it's so tied to the national recovery. In March, we would have said a couple of quarters because we would have expected traction this summer. But you're reading the same national news we are, and if that remains pessimistic that this could go on into '11.

Okay. Thank you.

If you want us to be more scientific about it, I can tell you that in looking at our migration analysis, we see nonperforming assets to continue to grow throughout this calendar year.

Matthew Clark, KBW.

Just to follow up on the OREO-related expenses, I know it was tied to two properties in the quarter, but just trying to get some sense as to how meaningful that cost might be going forward as you try to unload some of these properties as they go into foreclosure. Just, I'm assuming that's a cost of doing business that is going to remain for at least the next four or five quarters now.

Matthew, this is Terry. I think that's probably a good assumption of what that level will be. That certainly would be lumpy, and so it could be smaller than the $3 million we've commented on and that occurred in the second quarter. It could be larger, so that could be bouncing around. But I would expect over the next few quarters, we will see some cost of doing business around that OREO until they're liquidated and we see some more solid values in the underlying collateral.

Got it. Okay, thank you.

I'd like to follow up on that too. And again, I guess I'm emphasizing that different geographic areas are behaving much differently. We own residential real estate development in Cheyenne, Wyoming. And we are selling that one lot at a time through a local realtor, and the lot sales are happening frequently enough to where we are happy with how that's going.

And, the selling prices are right on the most recent appraised value. So, as we sell those lots, we are not taking any discount.

Now, contrast Cheyenne Wyoming with the Flathead, and it's a little different because we sold a subdivision up there in bulk. We did not sell it one lot at a time. We chose to take a bulk sale, so you're always going to take a heavier discount. And we actually sold that at 56% of appraised value, so, a 44% discount. But again, I want to give you a feel for the difference in geographic areas. And that's a pretty good explanation of how they're working for us.

That's helpful. Thank you.

(Operator Instructions). Gentlemen, we have no further questions today. Do you have any closing remarks?

I was hardly prepared for closing remarks. We thought we would have another 15 minutes of questions. But, I might just conclude by saying that we have optimism because the bulk of our franchise remains healthy. We have not had such a dramatic increase in credit problems where we have elected to take a huge loss in one quarter as other companies do, to clean everything off.

We tend to work with our clients longer. We tend to have longer and deeper relationships. So you will see our recovery from this crisis, if you will, a little slower, a little longer, but we think a little more profitable. We don't expect to have lost quarters. We expect to be a profitable company as we have been for the last 22 years.

And as I said earlier, we think our reserves and our underlying earnings power fortifies us for whatever credit problems we may see over the next few quarters. We appreciate you. We appreciate your confidence in the company, and we give you thanks for joining us today.

Thank you. This concludes today's conference. Thank you for joining. You may now disconnect.